As I consider investing in the stock market for the first time, I have been interested in high frequency trading (HFT). In the April 2015 edition of Vanity Fair, Michael Lewis, author of Flash Boys, published an article reflecting on his book, “a year after it shook Wall Street to it’s core.” For many, the take-away from Flash Boys, was that the stock market is rigged due to HFT. This type of trading is made possible through the use of powerful computer algorithms often times co-located within an exchange’s building.

While HFT utilizes technology that enables trading at amazingly fast speeds, the profit seeking strategies that these firms implement are less clear to me. One type of strategy is akin to market making, which does not seem to draw much criticism and has been exalted by some as a great liquidity provider. However, some HFT strategies are highly criticized and involve “front-running“ the market. A front-runner profits by discerning the intent of other investors and jumping in front of their orders, thereby causing the original traders to buy or sell at a less favorable price.

Average investors like myself are likely not significantly negatively affected by HFT. My understanding is that my desired price to buy or sell a stock may move by a small fraction of a dollar due to HFT. As for pension funds and other institutional investors trading at a much higher volume, this price difference could be very significant. That being said, institutional investors have the ability to “fend for themselves.”  See Dark Pools etc. For example, John D. Arnold a Vanderbilt graduate who managed Centaurus Advisors hedge fund claims to have “spent millions of dollars developing a proprietary order-entry system to disguise and conceal strategies from external algorithms.” This spending dynamic of obtaining and maintaining a speed and informational advantage on the market by HFT, as well as the reactive costs to protect market investments against HFT seems to be similar to rent-seeking. In addition, these days there is increased risk of market instability like Flash crashes. Do the benefits of HFT as a whole, such as more liquidity, really add anything of value to the securities market? Are there certain HFT strategies that do provide benefits and others that are counterproductive? These are tough but important questions for regulators to assess, and Michael Lewis has ensured that it is now part of the regulatory discussion.

 

–Joshua Sureck

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